People had always wondered, sort of academically, would it be possible to have a derivative chain reaction, some collapse that would lead to a so-called systemic crisis, meaning obviously that the system was threatened, not just one firm or two firms?

And that summer [of 1998], out of nowhere, Russia, which had been the darling of Wall Street -- everybody wanted to float bonds for Russia -- Russia defaults on their ruble-denominated debt.

And ... basically markets say: "OK, it was a bad move to take risks on Russia. We don't know what other risks are good. Therefore, we don't want any risks."

Long-Term Capital Management (LTCM) is a hedge fund in Greenwich, [Conn.], which really no one had heard of except for the Wall Street cognoscenti. It had fewer than 200 employees, had 16 partners, but was leveraged something like 30 or 40:1. Had all kinds of derivative bets, but all their bets were pointed one way, which was it was betting people would become less worried about risk.

And when they became more worried about risk -- and the firm had all sorts of models that said, no matter what happened, based on history, they couldn't lose more than $35 million a day -- they started dropping $300, 400, 500 million every day.

They had had $7 billion of capital. They thought they had so much capital, they gave back $3 billion to their investors right before this. Then they start losing these chunks.

Everyone else on Wall Street had similar bets to them. They're sort of sucked down into this vortex, and the more they try to sell out of these things, the more the steamroller goes.

And Wall Street freaks is what happens.

The New York Federal Reserve calls in the top 14, 15 banks to say: "LTCM's going to go down. Who knows who it'll take down with them? You guys ought to do something with them." And 14 banks agree to put up a few hundred million each, about $3.5 billion total. One bank refuses. That was Bear Stearns, incidentally. …

One of the things with LTCM is that no one had any idea. … No one knew how many other people had the same position and how much the market was on one side of it, how big that side was. And this was one of the things that making derivatives exchange-traded might go to.

So there was this momentary period when people said, "You know, we got pretty close to the edge." LTCM was a very scary moment.

It really was?

Yeah, it was very scary. Credit markets around the world just shut down. There was a two-, three-, four-week period of real panic. People were very, very frightened. Even Goldman Sachs lost a billion dollars. They had to cancel their public offering. Merrill Lynch lost a tremendous -- and these firms were worried about, in some cases, their future; in some cases, their survival.

It was a real bloodletting. So there was this shrinking back then. And people said a lot of things which they ended up not meaning, like, "We're never going to get leveraged again like this." Of course, they did. And, "We're going to look harder at derivatives." That was another one of the things they said that didn't last long.

[Who worked at LTCM?]

Long-Term had two Nobel Prize-winners, [economists] Bob Merton and Myron Scholes. Scholes, in particular, was a real free-market advocate. He used to say that only a fool paid his taxes. He didn't mean that people should be dishonest or illegal or commit crimes. He meant that anybody with a brain, half a brain, could figure out an honest way to get around them. And he was a specialist employed for that.

The firm also had the former vice chairman of the Fed, Alan Greenspan's number two, on it. It had a credo, too, LTCM, and the credo was really Alan Greenspan's credo. The credo was, "Markets get it right." … Because they get it right, people aren't going to be as worried about there being panics. And over time, prices will get more right and more right, which, to them, meant less and less worry. And therefore, we can bet against risk -- that is to say, bet against people being worried about risk.

So in some sense they were the personification or the embodiment of Alan Greenspan's credo in a financial firm.

What did they get wrong?

They got a couple things wrong. The famous saying attributed to Lord [John Maynard] Keynes -- I don't know if it's true or not -- but that markets can stay irrational longer than you can stay liquid. If you're not leveraged at all, if you just go out and, say, buy a stock or buy a bond and it goes down, you come back tomorrow. If it goes down the next day, you come back the day after that. And you just hang in there.

But if you're operating on somebody else's nickel, you don't have a tomorrow. If you're leveraged 10:1, and your asset goes down by 10 percent, you're wiped out. …

So one thing they got very, very wrong was thinking that not only would their bets be right, but they would always be recognized as right. It'd be never, ever a day when markets would say, "Hey, we're a little worried."

And they were fundamentally wrong in another sense, which is that markets were not as safe. There was this whole belief that recessions were done, the economic cycle was over, the Cold War was over. It was just going to sort of be happy sailing -- I mean, it sounds ridiculous now, but it wasn't ridiculous. It was a very seductive point of view after six or seven years of a gradually increasing, accelerating economy, mostly peace on earth, pre-9/11.

In their view, which they embodied in their trades, things are going to get better and better and better and better. We're done with history. It was [political scientist] Francis Fukuyama's thesis, if you could have canned that and put it into a financial trading engine.

And it turns out we weren't done with history. …

How did systemic risk emerge? What was at the heart of it?

A couple reasons. All of the major banks financed Long-Term. So as they saw Long-Term's ghost, they were looking at themselves, or the effect of themselves.

And they held a lot of the same assets. We call Long-Term a hedge fund and made a big deal out of it. It was a hedge fund, but all the investment banks and all the commercial banks had hedge fund-like operations. And they were all playing the same trade.

So as Long-Term was losing money, they were all losing money. And it was one of these vortex-like situations. So what happens, Long-Term, they start to try and sell to get out of it, and that drives down the value of their holdings more. And then the next guy says, "Well, if Long-Term's going to sell, I'm going to try and sell ahead of them." And possibly some people who weren't even in the investment started selling just to make money and enhance the misery of those who were in it.

I got a call from the Treasury Department probably the weekend that it nearly collapsed. This was in actually September '98. And I was told that the very large hedge fund was almost collapsing, that it had $1.25 trillion in notional value of over-the-counter (OTC) derivatives, and it only had $4 billion in capital to support that enormous investment, and that the markets had turned against it, ... so that it was going to default in a very major way, leaving the counterparties in the derivatives contracts -- who happened to be the big OTC derivatives dealers -- in the lurch in a major way. And I was told that the Federal Reserve Bank of New York was trying to facilitate an arrangement whereby the large over-the-counter derivatives dealers took over LTCM by buying it out.

What did you think when you heard that?

I thought that it was exactly what I had been worried about. None of us, none of the regulators had known until Long-Term Capital Management phoned the Federal Reserve Bank of New York to say they were on the verge of collapse.

Why? Because we didn't have any information about the market. They had enormous leverage. Four billion dollars supporting $1.25 trillion in derivatives? Excessive leverage was clearly a big problem in the market. Speculation? I mean, this was speculation, gambling on prices, on interest rates and foreign exchange rates of a colossal nature. Prudential controls? I mean, all these big banks had in essence ... extended unlimited loans to LTCM, and they hadn't done their homework. They didn't even know the extent of LTCM's exposures in the market or the fact that the other OTC derivatives dealers had been lending to them as well.

They thought they were the only bank, and there were 13 others on the list, right?

Well, at least there was a suggestion of that. There was some reporting of great surprise.

The other thing it showed me, which I hadn't really been aware of before, was the risk from tremendous contagion. Not only did these instruments, which supposedly are useful for managing risk, it multiplied risk and spread it around throughout the economy, but because of counterparty risk, one institution's failure could potentially bring down or adversely affect a large number of our biggest financial institutions.

The Federal Reserve opinion was that had the OTC derivatives dealers not stepped in and taken responsibility, this could have had a widespread, adverse, systemic impact on the financial system.

Meltdown?

Yes. A mini-2008, in effect.

One decade before?

Exactly. ...

So much for the argument that the market will somehow take care of itself and we don't need regulation, I guess?

It disproved it to me. I had never believed that. I think anybody who has been a lawyer practicing in areas involving business regulation realizes that the public interest is not fully protected by the marketplace and the participants in the marketplace.

So LTCM happens, and for a brief period there is this eagerness to regulate. ... But it very quickly evaporates. Why?

Because everything was all right. Because all the big banks did step in and solve the problem by taking over LTCM and incurring losses themselves. But they protected the fabric of the economy. And Congress was told by the over-the-counter derivatives dealers, by some of the other regulators, that this was an anomaly, this was not indicative of dangers in the market.

And I think any consideration of regulation probably came and went within a few days. …

At the time, the lessons actually came together in a report (PDF) of the President's Working Group that following spring. We felt that as a group -- and I helped to staff that report, because it's a report of the secretary of the Treasury and the head of the Federal Reserve -- some of the lessons [included] that we needed to do more to regulate these markets [and] that the private-sector firms also needed to do more around risk management, their risk with these entities.

I believe the report (PDF) that following [fall] was the first time we recommended greater oversight of derivative dealers which were affiliated with the Wall Street investment banks. It led to some of our recommendations later to have what's called centralized clearing of these derivatives.

But, looking back 11 years later, I think there's additional lessons about some of the moral hazard, what happens when government gets involved, even in a private-sector solution in the financial markets. ...

Did we miss something? Were there things that should have been learned from Long-Term Capital that were not learned?

I believe that looking back now, all of us, with the lessons we have from the 11 years passed, should have done more to protect the American public. Long-Term Capital Management was ... smaller ... than these large institutions, the AIGs and the Lehman Brothers and the Bear Stearns that brought the financial system to the precipice last fall. But I do think that there are lessons from that period of time about what we have to do going forward now. We have to lower the risk in the system.

One of the big lessons from Long-Term Capital Management is also that we have to make the system less interconnected. We live in a system that's highly connected, a global system. We all can go on the Internet and communicate with somebody in Malaysia or in France, or buy products. But also the financial system is similarly connected. If one big institution is going to fail, tumble, it's so connected it might bring down the other institutions and bring down the American public. And I think that the great lesson we started to see in Long-Term Capital Management, it was rather interconnected even for a hedge fund.

And I believe that's why we have to regulate derivatives now. We have to have these things called clearinghouses that help lower risk. They make the system less connected, these big financial institutions. We need to be able to let the system be less connected and thus, if one institution were to fail, less prone to hurt the American public.

Blythe Masters
CFO, JPMorgan; in 1997, she was part of a group at JPMorgan who created credit derivatives

I think that Long-Term Capital was … an enormous lesson in the dangers associated with allowing thinly capitalized, in this case hedge funds, to become major actors in the over-the-counter derivative space on an uncollateralized or unsecured basis.

The market practices around the management of credit risk associated with hedge funds changed radically as a result of that experience. And indeed, one of the things that has been quite notable during the course of all of this chaos is how very limited the impact of failure on the part of hedge funds has been to the system at large. And that is a notable positive that came out of that learning in 1998. …

The regrettable thing is that some of the inter-linkages between other financial intermediaries, and the broker/dealers in particular, really weren't raised by that event, and didn't have any additional light shed on them as a consequence. And so I don't think that the facts around the Long-Term Capital incident really had much bearing on what subsequently happened 10 years later.

The Long-Term Capital Management event was relatively quickly forgotten for a variety of reasons. Very few suffered from the event; there was no one that really had major losses, as such.

But the problem with Long-Term Capital Management continued on in bigger form later on. The use of derivatives accelerated afterwards and Long-Term Capital Management was a big user of derivatives. They had over a trillion dollars of derivatives that they had access to.

Number two, those who did the financing for Long-Term Capital Management, the various financial institutions, didn't really know the total involvement of the institution to which they were extending credit. Didn't know the total involvement.

But it was happening in a black box?

Well, they didn't know. But as a lender, you certainly should know with whom you're doing business and what they're doing. That carried on into much bigger size later on.

Plus, the techniques that were used by Long-Term Capital Management, the quantitative risk-analysis techniques that were used in judging one credit versus another, and working the spread between them, that quantitative risk-analysis technique accelerated rather than slowed down in the period afterwards or the period leading up to the recent crisis.

David WesselThe Wall Street Journal; author, In Fed We Trust

I don't think that LTCM stands for derivates are too dangerous to use. It wasn't any specific instrument that's their thing. It's the notion that you could have lots and lots of leverage. You could borrow lots of money and make bets on things that you're very confident you understand and discover that you don't understand as much as you thought.

And in a sense, whether it's derivatives or securitized mortgages or all these other financial instruments, each one has its own peculiar characteristics and risks, but all of them have this common thread: People who think they're really smart, think they can place a really big bet, borrow lots and lots of money to enhance their bet, and then discover they weren't as smart as they thought they were.

And there is an impulse right afterwards for some regulation to tighten things up a little bit, but that wanes fairly quickly. Nobody lost any money and, as you say, the taxpayer didn't get involved.

That's right. Even after Enron, with all its financial magic and everything, there's very little that actually gets done on regulation. I think that one of the lessons that they're trying to learn now is that if you have a financial crisis and you discover there are vulnerabilities in the system, it's logical to say we ought not to rush to regulate and do all that stuff. But the other side of it is if you don't rush, you don't do anything.

And so nothing much happened. Reports were written after LTCM about risk management and the firms. … There were lots of thoughtful pieces written about what the lenders ought to do, because that was one of the diagnoses, that it wasn't so much that LTCM did bad things. It was that LTCM did bad things, and everybody seemed to want to lend them money to do more of this stuff.

And so it led people to look at what should the lenders be told to do -- and the lenders are regulated in many cases -- so they don't get into this again. But a lot of these suggestions just fall on deaf ears and remain in the reports that stay on the shelves. Some get fixed.

It's easy to look back on the things that we didn't do and the problems that were caused. No one ever gets credit for the things that get fixed and then didn't blow up.

One thing that did come during the 2000s, partly as a result of some of the stuff that happened at LTCM, was the Federal Reserve Bank of New York was horrified to discover that a lot of this trading in derivatives and credit default swaps was being done in a very old-fashioned and sloppy manner, and that the paperwork was a mess. And that there would be days between the day that you sold something and that the other guy who bought it acknowledged that he had bought it.

They were worried that if you had a problem and the merry-go-round stopped, there would be a lot of disputes about who had done what to whom. And so they actually did clean that up.

We had huge problems. We made enormous mistakes. [But] it could have been even worse, hard as that is to believe, if there had been this paperwork problem.

And the one thing -- maybe the only thing -- that the Federal Reserve Bank of New York under Tim Geithner actually did that we saw had some effect was to get all these guys to say: "OK, you've got to have a modern financial back office here. We can't have the situation where huge percentages of your trades are unconfirmed and stuff."

So it's not like nothing happens after LTCM, it's not like nothing happens after Enron -- it's just we didn't seem to fix the fundamentals. We fixed some of the minor problems. …

Was one of the lessons of LTCM this systemic risk problem? …

Yes. One of the lessons of LTCM is that an individual firm, if it's big enough -- and more importantly, if it's interconnected enough -- can threaten the whole system. So, in that sense, LTCM was a warning that we didn't understand or didn't take heed of.

LTCM was one hedge fund, with not a lot of people, with a lot of borrowing, whose failure threatened the entire financial system.

Systemic risk.

Systemic risk. That's the definition of systemic risk. People talk a lot about "too big to fail." Well, what does that mean? It means that if you go down, you're going to take us all with you. And the judgment at the time was, if LTCM had an uncontrolled implosion, it would take us all with them. And so they worked out this rescue that didn't involve a lot of taxpayer money, and didn't do a lot of damage outside of the narrow fraternity. So it didn't affect the way we looked at finance in the rest of the world as much as we wish it had, now that we know.